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4/11/2011 @ 2:53PM7,540 views

PIMCO's Bill Gross Shorts Treasuries As Experts Eye Inflation

PIMCO co-founder Bill Gross added more fuel to the fire through the weekend as his Total Return Fund, one of the largest bond funds in the world, began to short Treasuries. Investors and experts are divided as to the fate of the U.S. government debt markets once the Fed ends its controversial QE2 program on June 30. Inflation expectations will be one of the key variables to watch, the consensus view seems to indicate, as it will mediate investors’ risk-appetite and thus channel funds either to risk or safe-haven assets.

Gross dumped all of his Treasury holdings in February. PIMCO’s total return fund, with $234 billion in assets, is one of the world’s largest bond funds, and any such movements are sure to rattle the market. While Gross publicized he’s bearishness calling June 30 “D-Day” as it would mark the end of the Fed’s $600 billion long-term asset purchase program and would surely lead to a tumultuous “handoff” of the bond market from public to private hands. On Sunday, ZeroHedge reported an approximately $7.1 billion short on Treasuries in Gross’ books, -3% on a market value basis. PIMCO, it seems, is betting on a precipitous dive of Treasury prices (which implies a spike on bond yields). (Read Don’t Expect Any Big Moves After QE2, RBS Strategist Says).

“Whether bond yields rise or fall after the current QE program is completed will depend on a host of factors. Chief among them will be market expectations regarding the outlook for economic growth and inflation, and expectations regarding the next move in Fed policy,” reads a note by HSBC’s global research team. Quantitative easing worked in that it boosted commodity and equity prices, thus making analysts raise their expectations for the rate of recovery of the U.S. economy. The end of QE2 will unmask the true strength of the underlying economy.

Subdued GDP growth and subdued core inflation will send yields even lower, according to HSBC’s analysts. “If economic growth is strong following the end of the QE program, then inflation risks may increase, especially as commodity prices are already at elevated levels,” reads the report. But this won’t happen, according to HSBC’s research team, and investors will see risky assets as less attractive and gradually return to Treasuries, avoiding a “problematic imbalance between demand and supply,” as Gross had predicted. (Read Don’t Expect Consumer Resilience To Rising Gas Prices To Last).

Dave Rosenberg seems to agree. In his latest commentary, Gluskin Sheff’s chief economist and strategist noted that demand continues to be anemic and inflation will remain more than subdued. Rosenberg explains that it is “hard to fathom” that commodities drive the inflation process. “The United States is not an emerging market where goods make up a significant portion of the spending bucket – services represent two-thirds of the pie and they have precious little to do with the price of oil and in fact look to be in a well-defined disinflationary downtrend,” Rosenberg says.

The strategist notes that the Fed’s QE programs have caused inflation in risk assets and commodities, but that stagnant wages are leading to demand destruction and deflation. While bond yields have “backed up from their recent lows,” Rosenberg sees it as a transitory phenomenon. “This doesn’t mean the 10-year Treasury note can’t go all the way back and retest the 4% mark but if it does, as we saw last year at this time, it will sow the seeds of its own demise and that of the equity market as well,” writes the strategist. Rosenberg, therefore, sees bond yields falling even further. (Read NY Fed’s Dudley: What? Food Inflation? At Least iPads Are Cheaper).

Is Bill Gross wrong, then? One possibility, stipulated in the HSBC note and referencing QE programs in the U.K, is an initial jump in yields follow by an even deeper fall, al double-dip. From the report:

The example of the UK’s 2009 QE program and its aftermath may be relevant in thinking about the end of the Fed’s current QE experiment. Gilt yields rose briefly at the end of 2009, only to fall to new lows in 2010. It appeared that economic fundamentals, namely expectations for growth and inflation, still ruled the market even after the Bank of England exited as a large-scale buyer.

Therefore, PIMCO’s short bet would be a short-term strategy. Profits would be taken relatively quickly, before markets turn back down again. That would play nicely with what PIMCO’s other chief investment officer, Mohammed El-Erian, told reporters when he said they could be buyers of Treasuries under the right conditions. “If the valuations of Treasuries get cheaper, we will revisit that” decision, El-Erian said.

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Bill Gross is under no circumstances “betting on a precipitous dive of Treasury prices.” If he was, he’d have MUCH more than 3% of his fund short. This is a teeny-weenie hedge position at most. Relax Augustino, relax!

Maybe I should have been more clear, it is not just the 3% short that shows that Gross thinks Treasury prices will take a plunge, it’s that plus his prior statements where he compared June 30 to D-Day and said they don’t want to be anywhere near Treasuries. You can read what he said in March here:

With rates 1 1/2% too low (150 basis points) and a minimal chance, according to Gross, that there is a smooth handoff between the public and private sector (in terms of the bond market), I think Gross is saying there’s gonna be a big move there, that’s why he compares June 30 with D-Day. At the same time, it is a bit much, maybe, saying he’s betting on a “precipitous dive”, it’s not much to say he’s betting on a big move.

While there is no doubt that the United States’ sovereign debt situation is critical, when put into perspective of the debt situation of the entire world, it appears that we have no real way of bailing ourselves out of this unstable house of cards.